Foreign lenders, limited in how much funding they can provide, watched from the sidelines. The deal size was beyond their reach.

‘China is a huge market, but it’s also a hard one to crack’

Five years after China said it fully met World Trade Organization obligations to open its economy to global financial firms, Citigroup Inc. and HSBC Holdings Plc are among companies still largely shut out of the world’s third-biggest banking market as they face government restrictions on adding branches and offering products. Foreign banks hold less than 2% of assets in China, the lowest share among major emerging markets, according to the International Monetary Fund.

“China is a huge market, but it’s also a hard one to crack,” said Liu Yuhui, director of financial research at the government-backed Chinese Academy of Social Sciences in Beijing. “Being huge means that you have to plow in billions and billions to build the franchise and customer base from scratch, not to mention that China’s banking market is highly regulated and well-entrenched by big state-owned players.”

Struggle to Expand

Global banks, long gung-ho on the promise of growth in a nation of 1.3 billion people, have struggled to expand retail and investment-banking businesses after spending US$60-billion in the decade since China joined the WTO and said it would open its markets. Obstacles to building branch networks have made it difficult to gather deposits and issue loans. Restrictions on stock and bond sales have thwarted investment banks, including Goldman Sachs Group Inc. and France’s BNP Paribas SA.

At the same time, state-owned banks such as Industrial & Commercial Bank of China Ltd., the largest in the world by market value, have been transformed from almost insolvent institutions into profitable firms with the help of more than US$650-billion in government bailouts. That has forced global lenders to retool their China strategies.

“Foreign banks have been over-optimistic about their business outlook in China,” Ivan Li, deputy head of research at Kim Eng Securities Hong Kong Ltd., said in an interview. “They can’t make good money in China as the market is dominated by Chinese lenders.”

Missing Out

Overseas banks have 387 branches in China compared with about 66,600 operated by the five largest state-owned lenders. They held just 1.6% of the nation’s 83-trillion yuan (US$13-trillion) of deposits and made 1.7% of its 58-trillion yuan in loans as of Dec. 31, according to the China Banking Regulatory Commission.

Foreign banks typically account for almost 50% of deposits, loans and profits in emerging markets, according to the IMF. They hold 22% of banking assets in Brazil and 5% in India. In the U.S., the figure is 18%.

Global banks combined have earned about US$10-billion in China over the past decade after spending US$27-billion to build their franchises and US$33-billion to buy stakes in local lenders, data compiled by the banking regulator show.

They’ve also missed out on a surge in lending over the past three years accounting for 45% of the nation’s total outstanding loans denominated in yuan. China’s banking system, with 114-trillion yuan in assets, is larger than the 30 other emerging markets tracked by Fitch Ratings combined and smaller than only the U.S. and Japan.

“Foreign banks have pretty much sat out a once-in-a-lifetime expansion opportunity in China,” said Liu, the Chinese Academy of Social Sciences researcher, who blames their lack of scale and relationships.

Retail Banking

Among the four largest U.S. banks, Citigroup is the only one building a retail-banking network. JPMorgan Chase & Co., Wells Fargo & Co. and Bank of America Corp. all have opted to steer clear of consumer banking in China and focus instead on treasury and corporate services.

“Retail banking is a scale business, and without scale you can hardly achieve anything,” said Shao Zili, JPMorgan’s chairman and chief executive officer for China. “Focusing on our wholesale-banking business in China at this stage is consistent with our current global strategy. We figured it’s neither efficient nor realistic to build a meaningful retail-banking network of our own at this stage.”

HSBC, Bank of East Asia Ltd., Standard Chartered Plc, Hang Seng Bank Ltd., Citigroup and DBS Group Holdings Ltd., the six biggest foreign banks in China by number of branches, had fewer than 1 million retail customers combined, compared with 260 million account holders at ICBC alone, according to a June 2011 survey by PricewaterhouseCoopers LLP.

‘China stands out as a country of unparalleled promise’

Most of those banks entered China in the 1990s with great expectations at a time when the country had unlimited needs for infrastructure financing and an underdeveloped banking system.

“China stands out as a country of unparalleled promise,” Charles “Chuck” Prince, Citigroup’s CEO at the time, said during a March 2007 trip to China while announcing a plan to double the number of branches that year to 30, a goal the New York-based bank didn’t achieve until 2010.

Citigroup, which opened its first office in China in 1902, has 49 branches there today. Its goal now is 100 by next year. By contrast, the bank operates 65 outlets in Taiwan, which has a population of 23 million.

Foot-Dragging

China had promised in December 2006, five years after joining the WTO, to remove geographic restrictions on overseas banks and allow them to start yuan lending and deposit services, as well as issue credit cards. Before that, the firms concentrated primarily on currency-exchange services for foreigners. The banking regulator then imposed an additional requirement that global banks, including those based in Hong Kong, incorporate locally to take deposits and offer services.

The firms have been permitted to open fewer than 10 branches a year and need approval to sell new products or appoint executives. It took Australia & New Zealand Banking Group Ltd. more than a year to obtain approval in March to accept yuan deposits from Chinese citizens.

“The problem is their branch expansion is limited by regulatory approvals,” said Dominic Chan, an analyst at BNP Paribas in Hong Kong.

Chinese banks, meanwhile, have been encouraged to expand. China Construction Bank Corp., the country’s second-largest lender, opened 166 outlets on the mainland last year and said in April it plans to add 2,000 more by mid-2016. Bigger rival ICBC added 421 locations last year.

Investment Banking

While the securities regulator agreed for the first time in October to accept applications from foreign banks to sell mutual funds, none has received approval. When China last year allowed HSBC to become the first overseas bank to underwrite corporate bonds on the interbank market, the London-based lender was told to be low-key about it and didn’t make an announcement, said a person familiar with the matter who declined to be identified because he wasn’t authorized to speak publicly.

Overseas firms need one license to underwrite stock and bond sales and another to trade local-currency securities. As a result, Chinese investment banks are dominant. UBS AG, among the few foreign securities firm with a full operating permit, had 3.5% of the underwriting market for domestic equities last year, the most of any non-Chinese bank. That placed it at No. 9, according to data compiled by Bloomberg.

Goldman Sachs, HSBC

Goldman Sachs executives said in December that the company, which didn’t do any deals last year, can be a player in China without leading in the IPO market. It is seizing opportunities in less risky areas such as institutional brokerage and advising wealthy Chinese clients, the executives said. The bank’s brokerage venture in China reported net income of US$8-million last year compared with US$4.44-billion earned by the entire company, according to its annual report.

Even in a country with a personal savings rate of about 50%, retail banking has been the biggest profit drag, according to data that banks started disclosing in 2009. HSBC’s China unit reported a loss of 112-million yuan on personal banking and 22-million yuan on private banking last year. At Citigroup, the personal-banking losses in its China arm widened 66% to 375-million yuan in 2011 from a year earlier.

Standard Chartered, with 85 branches, had a loss of about US$100-million on its China consumer-banking business last year, according to its annual report. The firm, based in London, missed an earlier expansion target. Chairman John Peace said in November 2010 that he expected to add 40 outlets in China by the end of last year. The company instead opened 19.

Seeking a Niche

HSBC, whose roots in Hong Kong and Shanghai date to 1865 and which now has 117 branches in China, hasn’t fared much better. CEO Stuart Gulliver said in February that he hopes to increase the bank’s China branch network to 800. Based on past speed of approval, it would take HSBC 70 years to reach that target. ICBC, by contrast, has more than 16,000 outlets.

HSBC, rather than pursue branch expansion, has decided to target specific businesses for growth, according to Helen Wong, CEO of the bank’s China operations. For corporate banking, it’s concentrating on companies with international needs such as trade financing and foreign expansion, she said. For depositors, HSBC is focusing on affluent Chinese with at least 500,000 yuan.

“Domestic banks already retain their natural advantage in their extensive nationwide network, so do you compete on those terms?” Wong said in an interview. “Probably not. You look at niche areas and enter where you can offer a good proposition with a competitive advantage.”

‘Competitive Market’

Peter Wong, HSBC’s Asia CEO, said five years ago that he expected the bank’s growth to be “especially brisk” in China’s retail and wealth-management markets, selling Chinese citizens everything from mortgages to credit cards to mutual funds.

Now, HSBC is no longer “trying to bank 100 million people in this marketplace,” Helen Wong said.

Foreign banks, which have 33,000 employees in China, also have struggled to find staff. A minimum of 10 people is needed to open a branch. As demand for experienced bankers has surged, companies have had to boost salaries to retain employees.

“It is a very competitive market,” said Mike Smith, CEO of Melbourne-based ANZ Bank, which announced plans to increase the number of outlets to 20 over the next decade from six now. “The issue has always been in the more senior, middle management. There just wasn’t the experience and expertise.”

Some banks have exited the retail market. Deutsche Bank AG, Germany’s biggest lender, stopped taking deposits from most Chinese customers on April 1 as the Frankfurt-based company shifted focus to clients with at least 5 million yuan. The bank will offer only private-banking services, especially wealth management, along with corporate banking.

Staying Afloat

Royal Bank of Scotland Group Plc in December 2010 abandoned its Chinese retail and commercial-banking businesses, which had 25,000 clients and US$900-million in deposits, giving the operations to Singapore-based DBS for free. Melvin Teo, DBS’s China head, said at the time that RBS decided to get out after a U.K. government bailout and record losses. RBS, based in Edinburgh, continues to provide banking services to large companies and institutional clients in China.

That business, known as wholesale banking, has helped foreign banks stay afloat in China by leveraging global networks and relationships with multinationals and financial institutions. Citigroup’s corporate-banking profit more than covered its retail arm’s loss last year. New York-based JPMorgan saw its China profit increase more than fourfold last year to 297-million yuan.

Doing It Better

Bank of America in February raised its three-year growth targets after profit rose faster than forecast, saying that China would become its largest revenue and profit contributor in the Asia-Pacific region in two years as the Charlotte, North Carolina-based lender takes advantage of foreign-expansion plans by Chinese corporations.

‘As a foreign player, you are the most welcome only when you can do something that Chinese banks can’t’

“I’m not a huge fan of the so-called foreign-local-bank strategy because that means you have to compete against these strong Chinese banks on all fronts and end up without having any focus,” Huang Xiaoguang, president of Bank of America in China, said in a February interview. “As a foreign player, you are the most welcome only when you can do something that Chinese banks can’t, or you can do it better than they can. That’s our current strategy.”

As overseas banks have struggled to find niches, Chinese firms have catapulted to profitability and sold shares to the public. China’s 3,800 lenders reported net income of US$35.4-billion in the last three months of 2011, one-third more than the total earnings of 7,357 U.S. banks, data from the China Banking Regulatory Commission and the U.S. Federal Deposit Insurance Corp. show.

Beijing-based ICBC may post a record profit of US$36-billion in 2012, according to the average analyst estimate compiled by Bloomberg, widening its lead as the world’s most profitable lender. JPMorgan, the largest U.S. bank, may earn US$18-billion this year, according to the Bloomberg survey.

Lending Capacity

Like Chinese lenders, foreign banks can’t lend more than 75% of their deposit base. With regulations barring loans of more than 10% of capital to a single borrower, competing for financing deals stretches the limits of foreign banks’ capacity. HSBC had 19-billion yuan in capital as of the end of 2011 and a loan portfolio less than that of the smallest of China’s 17 publicly traded banks, Bank of Ningbo Co.

That’s what sidelined foreign lenders when Shanghai Shendi Group Co., Disney’s Chinese partner, sought funding to build a theme park and resort in Shanghai’s Pudong district. Instead, the company lined up loans from Shanghai Pudong Development Bank, Bank of Communications Co., China Development Bank Corp. and nine other local lenders. The project, Disney’s first theme park on mainland China, is expected to open in 2015 and attract 10.5 million to 15 million visits a year, according to Xinhua News Agency.

China Eastern

While China Eastern Airlines Corp., the nation’s second- biggest carrier, has used foreign banks’ services such as underwriting bond sales in Hong Kong or financing aircraft purchases abroad, it relies on local lenders in China.

China Development Bank and Bank of China Ltd. are among firms that have offered the airline billions of yuan in credit, said Luo Zhuping, board secretary of the Shanghai-based airline from 1997 until his retirement in April. None of the foreign banks has enough capital to back up such loans, he said. China Eastern also uses ICBC to pay salaries to its more than 50,000 employees nationwide.

“They are convenient, simply put,” Luo said. “We have subsidiaries in over 20 provinces, and deposit and cash management are the most basic financial services we need, but there is no foreign bank with that extensive a reach in China to be able to handle it.”

Bank Stakes

For a time, foreign banks tried to partner with local counterparts, seeking minority stakes to participate in their profitability. Goldman Sachs, Bank of America, Zurich-based UBS, Citigroup and RBS were among global financial institutions that first bought into Chinese lenders and then sold about US$24-billion in holdings in the past three years as they replenished capital to meet global regulatory requirements.

Goldman Sachs and its affiliated funds sold US$2.5-billion of ICBC shares in April in its biggest and fourth divestment of stock. The U.S. bank has generated US$3-billion in gains on ICBC since purchasing a stake, according to company filings.

Citigroup in March sold its entire holding in Shanghai Pudong Development Bank nine years after purchasing it for an after-tax gain of US$349-million. Bank of America sold 10.4 billion shares of China Construction Bank in November for a profit of about US$1.8-billion, its fourth sale, leaving it with a 1% stake.

Raising the Ceiling

“Some foreign banks may no longer want a stake in Chinese commercial banks as that doesn’t fit in much to their strategy,” said Nicholas Yeo, head of China and Hong Kong equities at Aberdeen Asset Management Plc, which oversees US$295-billion globally. “They may want to focus more on their securities joint ventures, as that may be more useful to their investment-banking business.”

China last month raised the ceiling on foreign banks’ investments in such ventures to 49% from 33%, the first increase in more than a decade. Wall Street firms and their local partners have handled less than 4% of domestic corporate bond sales this year, underwriting 44-billion yuan of the 1.26-trillion yuan total, according to data compiled by Bloomberg. JPMorgan’s China venture has a 0.2% market share, even though the largest U.S. lender has arranged 6.5% of $1.8 trillion in global sales, the data show.

BNP Paribas pulled out of its three-year-old securities venture after a disagreement on strategy in January 2007. Morgan Stanley in 2010 sold its 34% stake in China International Capital Corp. after a 15-year involvement in the nation’s first Sino-foreign brokerage venture, to form a partnership with Shenzhen-based China Fortune Securities Co.

Credit Cards

Global banks say they expect to profit from new products, such as credit cards, that China is starting to allow. Citigroup announced in February that it will become the second foreign bank to issue its own cards in China. Permission came 10 months after the WTO said it would investigate a U.S. complaint about Chinese curbs on credit-card payment processing. China requires foreign banks to execute transactions through Beijing-based China UnionPay Data Co., a rule the U.S. says contravenes China’s trade obligations.

“Citi is a global pioneer in the bank-cards arena, and we believe the cards segment in China has huge growth potential in coming years,” said Stephen Thomas, a Shanghai-based spokesman at Citigroup’s China unit.

Bank of East Asia is the only other overseas bank with its own credit cards in China. It has been losing tens of millions of yuan a year on the business since it started in 2008 and is struggling to attract users, said a person familiar with the matter who declined to be identified because he wasn’t authorized to speak publicly. The Hong Kong-based lender had earlier planned to break even in four to five years.

‘Investment Phase’

“Foreign banks’ China business is still in the investment phase,” said Aberdeen’s Yeo. “It takes time and one has to be patient. But if you want to be patient, you need to have the capital or the resources to hang around.”

‘Even as some foreign banks are running at full speed, the gap is too wide for them to catch up in the decades to come’

In the meantime, global banks are working to make the best of whatever opportunities to arise.

“China is making good progress toward becoming a more open market,” said HSBC’s Helen Wong. “You just work within the realms, seizing on the opportunities available to you.”

As they wait, global banks risk falling further behind.

“Even as some foreign banks are running at full speed, the gap is too wide for them to catch up in the decades to come,” said Liu of the Chinese Academy of Social Sciences.